Reluctant Regulator: A special report.; Free-Wheeling Treasuries Market Is at Turning Point With Congress

When a Congressional committee convenes tomorrow to examine the Salomon Brothers scandal and its implications, it will set the stage for a battle over the regulation of one of the world's largest and most important financial arenas: the market for United States Treasury securities.

That market -- where $117 billion in bills, notes and bonds changes hands daily -- is the mechanism on which the Government relies to finance the nation's $3.61 trillion public debt. The unfolding scandal at Salomon Brothers is forcing a fresh examination of how the market operates, what rules govern it and how those rules are enforced. The recent query by the Securities and Exchange Commission to all big Treasury dealers is an effort to find out more about what really goes on in this important corner of Wall Street.

But even as the S.E.C. awaits its answers, the picture that is emerging shows a trading community governed under a poorly defined set of rules by a reluctant regulator: the Treasury itself, an agency that has grown increasingly dependent on the financial companies it oversees to channel the Government's flood of debt securities into investors' hands.

In the face of the Treasury's apparent reluctance to be a tougher policman, market participants say, some dealers have grown increasingly arrogant about their power and casual about overstepping bounds, putting the market's reputation at risk in the global finance community.

"People in this market have long had a belligerent attitude toward the regulators," said a top executive at a New York firm, stating a view expressed by many in the market. "They think, 'Hey, we're doing you a favor, so get out of our way.' " A Lot of Anger in Congress

The very nature of the misbehavior at Salomon -- the use of phony bids to buy more than the legal limit of Treasury securities, and the failure of top executives to take action when they found out -- has generated a lot of anger in Congress. One person there said the firm's activity "communicates a very high level of contempt for one's regulators."

At the same time, the common response to critics, heard even in the wake of the Salomon disclosures, is that the market is highly effective. Market professionals are warning Washington that clumsy attempts to regulate this market more tightly could impair its ability to function efficiently and could burden the taxpayer with higher interest costs.

"The rules in this market are certainly unclear," said Thomas A. Russo, a partner at the law firm of Cadwalader, Wickersham & Taft in New York. "They are not of the 20th century, and they should certainly be clarified. But Washington should not add two and two and get six. The Treasury market generally has worked very well, and regulators must resist the temptation to overreact."

The critical issue facing policy makers is to find a way to preserve the strengths of this vast debt-financing network while correcting a regulatory culture that one senior Wall Street executive said had turned the market into "an accident waiting to happen."

While the scope of Salomon's missteps took some by surprise, critics of the system say such problems are encouraged by the Treasury's light regulatory touch, combined with an equal reticence on the part of the Treasury's agent, the Federal Reserve Bank of New York. Treasury and Federal Reserve officials, for example, are said to have done little more than admonish firms when they have overstepped boundaries in the past.

"What you had was an honor system," said one senior Government official who insisted on anonymity. "It was not rationally designed. Authority and responsibility were not assigned in a clear-cut way. We have to sit down and design something that everyone is confident about to assure anyone looking at this market that this cannot happen again." The First Skirmish The Regulators Are Divided

Four Congressional committees have announced plans to examine the Salomon problems and the subsequent questions about the market's regulation. The first skirmish will be the hearing tomorrow of the Telecommunications and Finance Subcommittee of the House Committee on Energy and Commerce, led by Representative Edward J. Markey, Democrat of Massachusetts.

The key regulatory players will all be represented: Nicholas F. Brady, Secretary of the Treasury, which maintains that its oversight has been sound; E. Gerald Corrigan, president of the Federal Reserve Bank of New York, which conducts the Treasury's weekly auction but has shrunk from assuming regulatory oversight, and Richard C. Breeden, chairman of the Securities and Exchange Commission, which is showing signs of wanting to take a more active role, even as the other financial agencies hang back. Warren E. Buffett, the new chairman of Salomon Brothers, will also testify.

The S.E.C. is the watchdog for most securities markets, and its primary job is to protect investors. But it has almost no mandate in the Treasury markets except for cases that clearly constitute fraud. With its all-encompassing query to leading Treasury dealers and big investors, the S.E.C. has shown its eagerness to get involved. Differences Are Already Evident

While none of the agencies are saying much publicly about their views, differences are already evident.

Treasury Secretary Brady, in a recent telephone interview, defended the department's actions so far, saying they had sent "word to the world that we intend to conduct an honest market." At the same time, he said, the Salomon case has made it "worthwhile to review the process itself."

Mr. Breeden, on the other hand, seems to express more doubts about the adequacy of the current system. "Questions about the regulatory structure are not just questions of turf; they go to whether we can design a system that is likely to achieve our objectives," he said. "And our objectives here must be to finance Government at the lowest cost, but also to maintain a respect for law and integrity in the market."

In an interview last week, he gave no indication of what he thought might be needed to improve regulatory oversight of the market. "We are in the midst of a very active and very widespread investigation, and I would prefer to learn the outcome before I comment specifically," he said.

As the S.E.C.'s investigation proceeds, and as more is learned about the Salomon episodes, there is sure to be extensive debate on how to fix what went wrong. But even now, there are widespread predictions that the result will be more power for the S.E.C.

"You will never see the Treasury and the Fed totally supplanted," said Harvey Pitt, a partner at the law firm of Fried, Frank, Harris, Shriver & Jacobson. "They will set the tone and policy. But in terms of enforcement, it is simply logical that people will conclude that there was a vacuum, and that the S.E.C. is the most competent agency to fill it." A Bit of Dickens A Large, Simple Trading Machine

The Government bond market was born in 1791 as a byproduct of the original debt-financing activities of Alexander Hamilton, the first Secretary of the Treasury. For years, it existed as an unexciting backwater of the financial markets, the province of a handful of firms. In the late 1800's, the Treasury used only a single investment banker, Jay Cooke, as its agent in selling its debt.

Today, in a world increasingly linked by trade, the vast and still-growing market is a linchpin of the United States economy, as well as of the world economy. As it helps finance the Government, it also sets the benchmark interest rates that affect the cost of everything from home mortgages in New York and California to rates in London and Tokyo to the cost of the Brazilian debt.

For all its importance, the market is a fairly simple machine, a network of dealers who transact business over telephone lines and computer screens, rather than on some central trading floor. The core of the system is the primary market, the auctions where giant dealers like Salomon Brothers and Merrill Lynch and Citibank bid against each other for a share of billions of dollars worth of Treasury securities, ranging in maturities from three months to three decades.

The method by which the auctions are conducted is "right out of Dickens," as Joseph A. Grundfest, a former S.E.C. commissioner, put it. Written bids are due at the offices of the Federal Reserve Bank of New York on Liberty Street in lower Manhattan by 1 P.M. on the day of an auction. Some firms send runners to deliver their hand-scribbled bids to the Fed. Others install employees at a small bank of telephones in the Fed's lobby and relay their bids by telephone minutes before the deadline.

Back at the firms' trading desks, high-powered executives are talking feverishly to their counterparts at other firms and to their biggest clients, trying to get an idea of how strong the buying interest is. It is this judgment, combined with how rates are behaving in other securities markets, that helps the traders figure out where to peg their bids. Taking the Lowest-Rate Bid

A typical bidder might offer to buy "$2 billion at 8.25," which means the bidder wants to buy $2 billion in bonds paying an interest rate of 8.25 percent. The lower the quoted rate, the better the deal for the Government, so in this auction, the low bidder wins.

When all the firms have submitted their sealed bids, Fed officials take the best bids and announce them about an hour later.

In theory, anyone can buy the securities directly. In practice, however, the bidding is dominated by the giant firms, like Salomon Brothers, that have been designated by the Fed as primary dealers. They typically buy more than 80 percent of the securities at most Treasury auctions, for their own accounts and for customers.

These firms, which now number 39, agree to bid in all auctions and to continue to make a market in Treasury securities afterward. In return, they are the only bidders other than commercial banks that are allowed to submit bids on behalf of other buyers. They are also the firms the Fed uses to conduct routine purchases and sales of Treasuries to modulate the nation's money supply.

Orbiting around the small primary-market nucleus is the vast secondary market, where successful bidders resell the newly issued securities to other dealers and investors, who add them to the mountain of seasoned securities that change hands each day. A Free Market A Rule Born In August 1962

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The 1929 market crash led Congress to enact the set of laws that created the S.E.C. and empowered it to monitor securities markets in order to protect investors. But the Treasury market was largely exempted from that framework on the grounds that the Treasury was a uniquely solid credit risk and would not mislead investors.

As it moved to using more dealers, the main rules, which evolved over time, mainly focused on the conduct of the auction, including limits on how much any bidder could buy and who could bid. Dealers whose only business was selling Government securities in the secondary market were subject to virtually no rules at all until 1986.

A review of recent history shows that clearly codified rules and stern enforcement have never been a prominent characteristic of this marketplace. Several Wall Street executives and Government officials said behavior by a primary dealer that displeased the Treasury was most likely to result in a private frown -- and a brief public announcement of some small rule change that addressed the issue at hand.

For example, on Aug. 28, 1962, the Treasury tersely disclosed an "unusual occurrence" in the auction of three-month Treasury bills on the day before. A single bidder, unnamed, bid for an exceptionally high proportion of the total volume of three-month bills offered for sale. Rules Not in Any Codified Form

At the time, no rules prohibited such an aggressive strategy, although anyone who controlled a very large portion of a single issue might be able to extract near-monopoly profits later. The Treasury simply rejected the bid and announced that no single bidder would be awarded more than 25 percent of the total supply of three- or six-month Treasury bills in the future. The limits were gradually modified and extended to cover purchases of Treasury notes and bonds as well. Most rule changes were set out only in news releases, mailed to firms and not pulled together in any codified form.

Although dealers consistently seemed to find ways around each new rule, the Treasury continued its pattern of meeting each thrust by quietly tinkering with the rules. This continued through the 1980's -- a period during which the once-sedate government securities market went into overdrive.

The Federal deficit began to skyrocket, requiring the Government to begin borrowing on a scale that dwarfed anything the market had seen in its 190 years. The Government's debt has nearly doubled from 1980 to 1990 as a percent of gross national product, and the government securities market, ready or not, had to grow along with it.

Through this period, the primary market appeared relatively placid, but problems emerged in the secondary market, where Treasury securities are traded after they are issued. Some small, unregulated firms selling these issues were defrauding investors in various ways, including overcharging and borrowing against securities they did not own. These problems prompted Congress to propose legislation that would bring the secondary Treasury market under closer supervision. The hearings on those proposals now seem almost like a dress rehearsal for the current debate.

As administrative and industry witnesses came forward, legislators asked: Should the S.E.C. assume greater supervision and authority over the market? Should the rule-making authority for the market be shifted to the Federal Reserve? Did the Treasury's role as a huge issuer of debt conflict with its role as a market regulator?

In each case, the Treasury answered, "No." Paul A. Volcker, who was chairman of the Federal Reserve at the time, and John S. R. Shad, who was chairman of the S.E.C., supported the Treasury's position.

In the Government Securities Act of 1986, Congress left regulatory responsibility with the Treasury and omitted any rules over sales practices. But it gave the S.E.C. some power over the previously unsupervised dealers in the secondary market. The Bombshell Salomon Admits It Cheated

After 1986, other problems on Wall Street held Washington's attention until the bombshell fell on Aug. 9. That was when Salomon Brothers, one of the most powerful and respected brokerage houses on Wall Street, announced that it had cheated in several recent Treasury auctions.

It is still hard to measure who was harmed by Salomon's actions, and how much. Investors are already suing Salomon, contending that its actions artificially pushed up the prices of securities they bought. Shareholders in the firm are also suing it.

Perhaps the biggest concern is that the audacity of the misdeeds, and the Government's apparent slowness in reacting, could damage the credibility of the market, causing investors to stay away and forcing the Government to pay higher interest rates.

Recent auctions do not seem to have lacked for buyers. Nonetheless, the Salomon episode has generated uneasiness about the current regulatory structure -- especially Treasury's role in policing its own underwriters. Government policy experts say such an arrangement does not foster strong enforcement.

"It is very difficult to mix the regulatory function and other kinds of functions," said Michael Danielson, professor of politics and public affairs at the Woodrow Wilson School of Princeton University. "If my primary function is to sell something, and in the end I'm going to be judged on how effectively I sell it, then I am likely to have problems carrying out regulatory functions that get in the way." Relationship With Group Questioned

Some critics also question the Treasury's close relationship with an influential industry organization once known as the Primary Dealers Association, now the Public Securities Association. Its members, which include all the big bond-trading houses, consult with the Treasury on the structure and scheduling of new issues. Critics of the current framework point out that there is no separate unit at the Treasury charged with checking for rule violations by auction bidders.

Frances Bermanzohn, general counsel for the association, said there was nothing inappropriate in the group's relationship with the department. "There has never been any undue influence on the Treasury in its regulatory capacity," she continued. "Regulators invite and solicit industry feedback for information. Anything that has been done in this market has been in that spirit."

But not everyone is satisfied by that response. Even during the 1985 testimony, Aulana Peters, an S.E.C. commissioner, declared, "I do think that the Treasury Department would have a conflict of interest." She said she was "a little more comfortable" with moving the regulatory baton to the Federal Reserve. "But if I had my druthers," she added, the regulator "would be the S.E.C."

Others, too, have suggested that other agencies would be preferable to the Treasury, and the Fed is a frequent choice because, as the Treasury's fiscal agent, it is most familiar with the auction process. Need Seen for Clearer Division of Labor

If nothing else, the Congressional hearings are expected to call for a clearer division of labor among regulators in this market.

"One of the things that should come out of this is a more careful consideration of the rules that govern the entire market, and whether these rules are the best for the taxpayer," said Mr. Grundfest, the former S.E.C. member, who now teaches law at Stanford University.

For example, he said, the Government could change its auction methods entirely -- automating the process, encouraging more bidders or selling a broader variety of issues. These regulatory revisions, in Mr. Grundfest's view, might produce less risk of abuse and lower borrowing costs.

One common bet in Washington is that at the very least, the S.E.C. will be given power to gather more information about the Government securities market. "It is inevitable that one of the recommendations you'll have to see come out of this," said Mr. Pitt, the lawyer, "is that the Government will start now to collect data in a more rigid way."

The immediate focus for the debate will be the reauthorization of the Government Securities Act of 1986, which will expire in October unless renewed. Although the act was meant to deal with problems in the secondary market, similar concerns have emerged following the disclosures about Salomon's behavior in the primary market. 'Broader Issues' Said to Be at Stake

The big question now, Represenative Markey said, "is the broader issues surrounding the need for reform of the Government securities market." His committee and others, he added, need to explore "where we, in the Congress, need to go from here."

Treasury officials seem hopeful that they will be able to keep their pre-eminence as the regulator for their market, although they will not rule out the adoption of new procedures within the department. "We feel our authority is sufficient," one official said, "and we have begun reviewing the rules governing Treasury auctions to see what, if any, changes would be appropriate."

However the Washington power struggle turns out, it is likely that the fate of Salomon Brothers itself will be more instructive to Wall Street than anything either Congress or the Treasury could cook up. As Victor Chang, a former bond market executive and now the head of his own investment advisory firm, said after the resignation of John H. Gutfreund, Salomon's former chairman, and his two top executives: "This problem, and the way it was resolved, with three top people losing their jobs, will do more to prevent future abuses than any piece of legislation which could be introduced."

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A version of this article appears in print on September 3, 1991, on Page A00001 of the National edition with the headline: Reluctant Regulator: A special report.; Free-Wheeling Treasuries Market Is at Turning Point With Congress. Order Reprints|Today's Paper|Subscribe